I'm the Beijing Bureau Chief for Forbes. I joined the magazine in Bangkok where I covered Southeast Asian business and politics for over a decade, taking me deep into the weeds in Indonesia, Myanmar and Thailand. In my new role I blog on all things China, from tech whizz success to political bottlenecks and botched acquisitions.

Shine A Light On China's Underground Banks, Shady Bankers

Delegates to China’s annual legislative meetings have called for legal oversight of shadow banks that make unsecured loans to business owners. Their recommendation, reported Monday in the South China Morning Post (paywall), comes as China’s economy begins to cool after a massive lending spree. Shadow banking operations range from informal neighbourhood lenders to loosely-regulated trusts, and have become a hot topic in China. In 2009, millionaire businesswoman Wu Ying was convicted 2009 for illegal lending and fraud. Wu was sentenced to death, but the Supreme Court recently said it was reviewing the case “with caution” after a public outcry. Several delegates to the National People’s Congress echoed calls for careful review of the case. Wu built her wealth in Zhejiang Province, a hotbed of informal lending and trust firms. Aged 31, she’s a poster child of entrepreneurship whose plight has has drawn attention to the application of the death penalty as well as the murky world of informal financing.

According to Fitch Ratings, around half of new loans in China are now made by shadow banks. One reason is that state-owned banks (the Big Four) mostly lend money to state enterprises, depriving entrepreneurs of capital. Another is that deposit rates were set well below inflation, at least until recently, so savers sought out higher returns on their money. The result is a thriving underground banking system that is well known to authorities but not properly regulated. Peer-to-peer lending by online sites is also flourishing. Private loans aren’t illegal, but they’re clearly not protected by the courts. That’s why protests have erupted when lenders have found themselves out of pocket. In coastal areas like Zhejiang the practise has deep roots, according to the SCMP.

Such informal lending practices could be traced to ancient times, when they were used by those needing large amounts of money to start up businesses at a time before banks even existed, said Ming-Jer Chen, a professor at the Darden School of Business at the University of Virginia.

People from the same villages, very often relatives and friends, would pool money to support those in need of cash, in return for an interest payment.

Although such informal lending channels are now defined as illegal on the mainland, prohibition never halted all the underground banking. Media reports of people losing money through such lending groups persisted throughout the 1980s and 1990s.

“They have this kind of culture in Zhejiang and people are willing participants. All the government needs to do is to make sure that the money really is used for investment and there isn’t any fraud,” said Zhang Xiaoji, a scholar at the Development Research Centre (DRC) of the State Council.

Unregulated lending can be highly risky, as Wall Street discovered when its derivatives factory went up in smoke in 2008. China’s shadow banks have helped property developers to evade curbs on bank credit and helped banks to shift loans off their balance sheets. For borrowers, this is very convenient, if expensive (annual rates of 10-15% are common). The problem usually comes when asset prices fall and loans go bad. Some trusts are backed by state companies, which have access to cheap credit from formal banks. And so the merry-go-round continues. In effect, small business owners are paying higher-than-normal rates because big banks aren’t willing or able to price risk. This is one downside of China’s state-led capitalism. Nor do state-controlled banks seem to be creating wealth. Central bank chief Zhou Xiaochuan said Monday that Chinese banks faced a capital shortage in 2012. Bad loans aren’t just in the underground sector.

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The Chinese state banks don’t create wealth? Last year the Chinese state banks collectively made a profit of about 300 billion dollars. The state-owned ecterprises are very crucial to the Chhinese econmy,because they can plan long term strategies for the good of the country as a whole, instead of worrying about short term outlooks. Contrary to the popular belief, these SOEs became very competitive over the years. But also their share of GDP has been declining very rapidly over the years. In spite of all the hardships of getting loans from the state banks, the Chinese private sector controls about 60%-70% of the Chinese GDP, thanks to the help from the informal banking sector. But China must have market-set interest rates and legalize the informal banking sector,in order to have a sustained growth.

Given that net interest margins are fixed by PBOC and that banks don’t really compete for deposits, it’s hard not to make fat profits. Yet the same banks are said to be seeking to raise more capital. How odd. Agree that SOEs are getting stronger; whether or not they’re internationally competitive is harder to judge. As for China’s private sector accounting for 60-70% of GDP, it depends on how you definite private.